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Monday, January 28, 2008

More about the Fed’s 75 basis-point reduction

It's been stated and re-stated all week long that the Fed made an inter-meeting rate cut due to falling equity prices in the global markets. My guess was that there was more to the story, but I didn't really have the time or the resources to find out. Instead I looked forward to John Mauldin's weekly e-newsletter (click here to subscribe), knowing this was a big enough story that he would dig into it in greater detail. And he did not disappoint!

John offered 2 opinions that I had not yet heard; one of many of his colleagues, and then his own differing opinion:

1. Fed's Folly – Fooled by Flawed Futures

It seems that a rogue trader lost Societe Generale $2.2 Billion over the last few weeks before management found out. Once the European bank started making trades to cover their losses, they caused an over-supply in the marketplace (eventually accounting for over 10% of all trades), which caused prices to move away from them. They ended up losing over $7 Billion in a very short time frame.

Many insiders believe that the European Central Bank knew what was going on, but that our own Fed either did not know or wanted to make a bold statement. Either way, it's possible that this move will end up looking very foolish, and the Fed will have egg on its face for decades to come.

2. The Start of Something Bigger

Mr. Mauldin believes that there is a deeper underlying problem (worse than the sub-prime mortgage mess) which has yet to unravel. The Fed is trying to set the stage for the carnage we'll see over the next few months. I'm quoting various parts of his newsletter below (emphasis mine):

"I believe the monoline insurance companies like Ambac and MBIA are in worse shape than most realize, the counter-party risk in the $45 trillion Credit Default Swap market is much worse than we realize, and the exposure by various banks to their problems is much larger than currently understood. The Fed understands this, and realizes that they have been behind the curve but need to catch up."

"If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss."

"No one is really sure who owes what and to whom, and what is the risk that there may be no one to pay that CDS when it comes due? The entire mess is going to have to be unwound in the coming quarters. it may take a year or more."

"Think this through. MBIA is still rated AAA. Ratings downgrades are just a matter of time. Banks that raised $72 billion to shore up capital depleted by subprime-related losses may require another $143 billion should credit rating firms downgrade bond insurers, according to analysts at Barclays Capital. "

"I think the concern that there is the potential for a much worse credit crisis than we are currently experiencing is what is driving the Fed. They are looking at the problem from the inside, and realize that they simply have to engineer a much steeper yield curve to allow the banks to make enough profits so that they might be able to grow their way out of the crisis over time.

If I am wrong and the Fed was responding to the stock market, then we will likely not see a cut this next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut the next meeting and the next until we get down to 2% or below.

A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking. We will see."

3. My own opinion?

I'm not going to bet against John Mauldin, but we'll know more after the Fed's next meeting. If John is right, then we're going to be looking at an extended period of very low interest rates.

Banks will have a big appetite for making new loans, especially if they're getting money at 2-3% and lending it out at 6%. They won't get over zealous, like they did a few years ago, and give loans to those who can't make payments. But they will want to make loans to anyone who is capable of making the mortgage payments – they're going to need as much income as possible to cover their losses.

We should be seeing a decrease in the number of ARMs resetting each month, which means we should be seeing a decrease in the number of new, bank-owned properties hitting the market. If the inventory of homes for sale levels off (which it should), and people continue to move to Arizona (which they will), and banks want to make new loans (which they should), then we should see a change in our local market over the coming quarters.

Your looking forward to the change Realtor,

Chris Butterworth

Copyright compliance: John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore

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